Query No. 9

Subject:           Recognition of sale for despatches made to sub-contractors on partial completion of the product.[1]

A.        Facts of the Case

1.         A company (hereinafter referred to as ‘the company’), which is a Government of India undertaking under the Ministry of Defence, manufactures a wide range of products like super alloys, titanium alloys, maraging steel, etc. for strategic sectors like Space, Defence, Nuclear power, etc. The products manufactured are sold in the form of ingots, forged billets, sheets, plates, strips, rods, rings, etc. To enable the supply of material in the form specified by the customers requiring special operations like machining, rolling, ring forming, etc. for which facilities are not available in-house, such jobs are off-loaded to the sub-contractors in India. The company’s turnover in the financial year 2011-12 was to the tune of Rs. 509 crore.

2.         The querist has separately clarified that the company is getting orders for products viz., Maraging Steel Rings and Plates, meant for projects of national importance. These products are customised products which do not fall in the company’s standard products, as the manufacturing process of rings and plates requires processing at external sources due to facility constraints. The time involved at each stage and production cycle time are given below. This schedule does not include raw material procurement time-

The customer gives his own specifications for the products to be delivered which are mutually discussed and agreed upon before accepting the order and before taking up manufacturing. These products are specific customised products and require special skills and facilities. The raw materials required for manufacturing these products are Nickel, Cobalt, Molybdenum, Pure Iron, etc., and are imported. Purchase orders/work orders are received before the commencement of production and the manufacturing is taken up only after the receipt of specification for the product. These products are complex in nature as processing of these products requires special skills, knowledge and facilities. These products are made of alloys which are vaccum melted and processed with controlled chemical composition using vacuum grade raw materials. These alloys find application in Indian strategic sectors, like, Indian Space programme-launch vehicles, Defence-Missile programme and nuclear application. According to the querist, the manufacturing activity of the products does not fall under construction activity but can be categorised as production activity. Since the activity does not fall under construction activity, the end product does not result into construction of any complex equipment. However, the products are used by the customer in manufacture/assembling of Polar Launch Vehicle/ Geo Stationary Launch Vehicle.

3.         The querist has stated that the company had referred a query in the year 1996-97 to the Expert Advisory Committee regarding accounting and recognition of deemed sale as per its accounting policy in respect of the contracts for supply of items requiring long production cycle time which involved intermediary/final operations outside the company. Till date, the company has been following the same accounting policy and has been accounting its revenue in line with Accounting Standard (AS) 7[2], Accounting for construction contracts,  which was applicable for the long production cycle items as was opined by the Expert Advisory Committee in the year 1996-97 (published in the ‘Compendium of Opinions’-Volume XVII as query no. 1.10). The company has been consistently following the above-mentioned practice of recognising sale and all along statutory auditors and C&AG auditors have accepted such practice.  However, during audit of the accounts for the year 2011-12, the C&AG auditors have again re-looked at the accounting policy and raised query. The query of the C&AG auditors and the reply of the company are placed below:

Query:

“Statement of Profit and Loss – Revenue from operations – Rs. 49,630.51 lakh – (Note No.23) – Sale of manufacturing products – Rs. 48,122.36 lakh.

This includes Rs. 11,603.67 lakh representing income from despatches to sub-contractors recognised as per significant accounting policy no.8.

In respect of supply contracts, where production cycle exceeds one year and intermediary/final operations are required to be undertaken outside the company, materials are sent to sub-contractors. The company recognises a deemed income against these despatches, as per its accounting policy no.8 and reflects the same as accrued income (despatch with sub-contractors) in the balance sheet as a current asset. On return of materials from sub-contractors, deemed income (to the extent of value of materials returned) recognised earlier is reversed and accounted as sales adjustment.

As at the end of financial year, the outstanding balance of materials with sub-contractors are reflected at net value under current assets after pro-rata adjustment of related advance received from customers.

The above accounting treatment is claimed to have been followed as per Accounting Standard 7 (Construction Contracts) applicable where the accounting process involves measuring results of relatively long term events (more than one year) and allocating those results to relatively short term accounting periods.

It is observed that the revenue recognition of Rs.11,603.67 lakh is not in order and does not qualify for recognition as per AS 7, in view of the following:

AS 7 is primarily applicable to construction contracts specifically negotiated for construction of an asset or a combination of assets (i.e., tangible assets). The products despatched by the company to sub-contractors does not qualify for such classification.

Materials are being despatched for intermediary/final operations to sub-contractors (Vendors) and not customers. Hence, the processes involved are despatches to sub-contracting activities and not a sale. Accordingly, the gross value of accrued income reflected in balance sheet as current asset is the value of materials lying with sub-contractors.

As per paragraph 11 of AS 7, contract revenue is measured at the consideration received or receivable. Being a transaction with sub-contractors, receipt of consideration does not arise. Moreover, as stated by the company in response to an observation issued during Phase II of certification audit, since no sale takes place, income is not debited to sundry debtors (trade receivables). Instead, deemed income is initially treated as current asset on despatch and reversed on return of materials from sub-contractors thereby reducing sales revenue of respective year to that extent.

No disclosures are made regarding the amount of contract revenue recognised during the accounting period and methods used to determine the stage of completion of contract in progress. Further, necessary disclosures are not made regarding aggregate amount of costs incurred and recognised profits (less recognised losses) upto reporting period, the amount of advances received and amount of retentions.

Moreover, AS 7 does not provide for reversal of stage-wise sales recognised in earlier years upon completion of contract / construction of assets. The company had earlier agreed, during Phase II of certification audit, that there is no transfer of risks and rewards at the time of despatch to sub-contractors. Hence, the practice followed by the company did not comply with requirements of either Accounting Standard 7 or Accounting Standard (AS) 9, ‘Revenue Recognition’  to qualify for recognition of revenue.

Under the circumstances detailed above, considering the reversal of deemed income of Rs. 9,092.46 lakh from sales made in the books during the accounting period, the revenue from operations is overstated by Rs. 2,511.21 lakh.

In the absence of disclosure regarding aggregate amount of cost incurred, considering the margin of 23% indicated in working details furnished, the profit is overstated by Rs. 577.58 lakh.”

Management Reply:

“Basically, the method of accounting to be followed is on accrual basis to maintain consistency in revenue recognition on going concern concept. Same issue was raised by audit in their Phase 2 audit vide Audit Enquiry No.12 dated 21/6/2012 and reply was submitted. As the issue is raised again, it is submitted as under referring to the Expert Advisory Opinion sought earlier:

Accounting Standard 7 is primarily applicable to construction contracts.

With regard to production cycle items taking more than a year to complete, in respect of which the company is recognising revenue before completion thereof, the Committee notes  that AS 7 (issued 1983), on ‘Accounting for Construction Contracts’ states about the applicability of the Standard, inter alia, in paragraphs 2 and 3 thereof, as below:

“2.       …The specific duration of the contract performance is not used as a distinguishing feature of a construction contract. Accounting for such contracts is essentially a process of measuring the results of relatively long-term events and allocating those results to relatively short-term accounting periods.”

“9.2     The stage of completion used to determine revenue to be recognised in the financial statements is measured in an appropriate manner. For this purpose, no special weightage should be given to a single factor; instead all related factors should be taken into consideration; for example, the proportion that costs incurred to date bear to the estimated total costs of the contract, by surveys which measure work performed and completion of a physical proportion of the contract work.”

“17.1   …The costs attributable to the contract can be clearly identified so that actual expenditure can be compared with prior estimates.”

Thus, a matching concept of revenue recognition with respect to the expenditure incurred during the financial year is the basis of AS 7, which is adopted by the company. As otherwise, the expenses are incurred in one year or more than one year and revenue is to be recognised only on completion of the product ready for delivery, which distorts the total operating results of the organisation from year to year as most of the products are of long cycle in nature which is beyond 12 months.

Accounting Policy 8 clearly brought out the basis of recognition of revenue proportionately connected to each stage of completion. However, as explained to auditor during their third phase of audit, the issue is becoming a concern year by year and the same was placed before the Audit Committee for review and suggestion and the Audit Committee also, after going through in detail and taking into consideration the practical difficulties faced by the organisation in view of non-availability of facilities as well as dependence on few work centres for processing the product resulting in long cycle time, agreed to bear with  the Accounting Policy No.8 for another year or two till in-house facilities come up so that the policy can be reviewed and suitable modification to the measure of accounting can be carried out.

In view of the above, the audit enquiry may please be dropped.”

4.         As per the querist, the basis for adopting AS 7 earlier was matching of expenditure and income in order to ensure that operating result of the company reflects the actual activity as well as income, failing which it may distort the results in any year and abnormally boost the results in another year.

5.         The querist has explained the accounting entries involved. The following accounting entry is passed when the material is sent for job work.

When the material is received back by the company from the sub-contractor, the income recognised on those despatches (to the extent of the materials received back) is reversed in the books. The following accounting entry is passed in the books of account.

When the finished product is sent to the customer, the following entry is passed:

At the year-end, the outstanding balance in the ‘Despatches with sub-contractors’ is disclosed as ‘Accrued Income’ (under ‘Current Assets’). The company pays to the sub-contractor for the services rendered on the goods as the job is completed by the sub-contractor and material is received back by the company.

6.         Last five years’ position regarding above transactions are summarised below:                  

                                                                                                                               Rs. in crore

7.         As per the C&AG auditors, the system of accounting deemed income, which the company claims to be in line with AS 7, is not correct and needs a re-look in view of the fact that invoices are not raised and no consideration is received from the sub-contractor, as the sub-contractor is not the customer of the company. Material issued to sub-contractors cannot be recognised as revenue either under AS 9 or AS 7 and, hence, the system followed needs to be reviewed.

8.         In view of the long production cycle time that takes for the final product to be manufactured which spans over more than twelve months of time, the querist has sought the opinion of the Expert Advisory Committee (EAC) regarding its Accounting Policy No. 8, which is as under:

“In respect of the contracts for supply of items requiring long production cycle time which involve intermediary/final operations outside the company, income is recognised proportionately as under:

(a) Where prices are available for each stage of completion: The price appropriate to the stage of completion.
(b)Where prices are not available for each stage of completion: 

 –90% as the case may be, of the final contract value for the item less estimated cost to be incurred for completing the item.

-Balance is recognised as income on completion / acceptance and despatch of the item.”

B.        Query

9.         The querist has sought the opinion of the Expert Advisory Committee on the following issues:

(a) Whether the accounting policy of the company with regard to setting up of sales based on the semi-finished products sent to sub-contractors for further processing without invoices being raised on the final customers is in line with AS 9, ‘Revenue Recognition’.

(b) Whether the accounting policy according to which the company is taking into books, the value of despatches to sub-contractors upto the stage of completion as income where production operations are spread over more than one financial year is in line with AS  7, ‘Construction Contracts’.

C. Points considered by the Committee

10.       The Committee notes that the basic issues raised by the querist relate to recognition of sales in respect of semi-finished products sent to sub-contractors for further processing and considering value of despatches to sub-contractors upto the stage of completion as income when production operations are spread over more than one financial year, in the context of two specific end products viz., Maraging Steel Rings and Maraging Steel Plates. The Committee has, therefore, considered only these issues and has not examined any other issue that may be contained in the Facts of the Case, such as, accounting entries passed at various stages, exhibition of value of materials with sub-contractors as accrued income after pro-rata adjustment of related advance received from customers under ‘Current Assets’ in the balance sheet, treatment in respect of any other end-product, etc. The Committee presumes that the C&AG auditors’ query and management’s reply reproduced in paragraph 3 above are in respect of the two specific end-products mentioned above. The Committee also notes that as per data provided by the querist, the production cycle time in respect of these products have reduced to 198 days in case of Maraging Steel Rings and to 250-295 days in case of Maraging Steel Plates, which is different from the facts of earlier query where the products had involved long production cycle time, viz., more than a year. Thus, although the querist states to have applied the earlier opinion of EAC but the Committee notes that the facts of the extant case, as provided, do not seem to be on par with the facts given in the year 1996-97. Moreover, the Committee notes that the production cycle of the said products is prolonged mainly due to dependence on few work centres for their processing (refer Management Reply in paragraph 3 above) and thus, the products manufactured per-se cannot be considered to have a long production cycle.

11.       The Committee notes that the two specific end-products, viz., Maraging Steel Rings and Maraging Steel Plates are customised. They are used by the customer in the manufacture/assembling of Polar Launch Vehicle/ Geo Stationary Launch Vehicle. The Committee notes that AS 7 is applicable only in case of construction of an asset or a combination of assets in accordance with a contract specifically negotiated for construction of the same or when there is any rendering of services which are closely related to the construction of the asset. In this connection, the Committee notes the following extracts from AS 7, notified under the Companies (Accounting Standards) Rules, 2006 (hereinafter referred to as the ‘Rules’):

“2.1 A construction contract is a contract specifically negotiated for the construction of an asset or a combination of assets that are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use.”

“3. A construction contract may be negotiated for the construction of a single asset such as a bridge, building, dam, pipeline, road, ship or tunnel. A construction contract may also deal with the construction of a number of assets which are closely interrelated or interdependent in terms of their design, technology and function or their ultimate purpose or use; examples of such contracts include those for the construction of refineries and other complex pieces of plant or equipment.

4. For the purposes of this Standard, construction contracts include:

(a) contracts for the rendering of services which are directly related to the construction of the asset, for example, those for the services of project managers and architects; and

(b) ...”

The Committee notes from the above that there should essentially be a ‘construction of asset’, in order to become AS 7 applicable. The Committee further notes that the querist has clarified in paragraph 2 above that the manufacturing activity in respect of the two specific end-products does not fall under construction activity but can be categorised as production activity and that while the manufacturing process may be complex, the two specific end-products are not complex pieces of equipment. The Committee also notes that manufacture/assembling of Polar Launch Vehicle/ Geo Stationary Launch Vehicle, done by the customer of the company and not by the company itself, may be considered as a complex piece of plant or equipment as contemplated under paragraph 3 of AS 7. However, manufacture of their parts, which is being done by the company cannot be considered as complex pieces of equipment. Accordingly, considering the nature of products being manufactured, the Committee is of the view that AS 7 is not applicable for revenue recognition in respect of the two specific end products. Only AS 9, ‘Revenue Recognition’, is applicable for revenue recognition in respect of the same. In this regard, the Committee also wishes to point out that AS 7 also does not envisage recognition of revenue on despatch to the sub-contractors, rather requires recognition of revenue by reference to the stage of completion of the contract activity at the reporting date.

12.       The Committee notes that AS 9, notified under the Rules, prescribes the following criteria for revenue recognition:

“6.1 A key criterion for determining when to recognise revenue from a transaction involving the sale of goods is that the seller has transferred the property in the goods to the buyer for a consideration. The transfer of property in goods, in most cases, results in or coincides with the transfer of significant risks and rewards of ownership to the buyer. However, there may be situations where transfer of property in goods does not coincide with the transfer of significant risks and rewards of ownership. Revenue in such situations is recognised at the time of transfer of significant risks and rewards of ownership to the buyer. Such cases may arise where delivery has been delayed through the fault of either the buyer or the seller and the goods are at the risk of the party at fault as regards any loss which might not have occurred but for such fault. Further, sometimes the parties may agree that the risk will pass at a time different from the time when ownership passes.”

“10. Revenue from sales or service transactions should be recognised when the requirements as to performance set out in paragraphs 11 and 12 are satisfied, provided that at the time of performance it is not unreasonable to expect ultimate collection. If at the time of raising of any claim it is unreasonable to expect ultimate collection, revenue recognition should be postponed.

Explanation :

…”

“11. In a transaction involving the sale of goods, performance should be regarded as being achieved when the following conditions have been fulfilled:
(i) the seller of goods has transferred to the buyer the property in the goods for a price or all significant risks and rewards of ownership have been transferred to the buyer and the seller retains no effective control of the goods transferred to a degree usually associated with ownership; and
(ii) no significant uncertainty exists regarding the amount of the consideration that will be derived from the sale of the goods.”

13.       From the Facts of the Case, the Committee notes that there is no transfer of significant risks and rewards of ownership when the semi-finished products are despatched to the sub-contractors for further processing. (Refer C&AG Auditors’ Query reproduced in paragraph 3 above). In other words, there is no sale to the sub-contractors. In fact, as stated in paragraph 5 above, the company pays to the sub-contractor for the services rendered on the goods by them. Further, the Committee also notes that at the time of despatch to sub-contractors, there is no transfer of significant risks and rewards of ownership of semi-finished products to the final customers, since, only finished products are delivered to them. Thus, the criterion of transfer of significant risks and rewards of ownership prescribed in paragraph 11(i) of AS 9, reproduced in paragraph 12 above, has not been met in the extant case in respect of semi-finished products despatched to the sub-contractors. Accordingly, the Committee is of the view that no revenue from sales should be recognised on despatch of semi-finished products to the sub-contractors for further processing. Incidentally, the Committee wishes to point out that mere raising invoice on the customer cannot be considered as a criterion to recognise revenue  under AS 9 and the other conditions of revenue recognition relating to transfer of significant risks and rewards of ownership, etc. as per AS 9 need to be met.

D.        Opinion

14.       On the basis of the above, the Committee is of the following opinion on the issues raised by the querist in paragraph 9 above:

(a) The accounting policy of the company with regard to setting up of sales based on the semi-finished products sent to sub-contractors for further processing is not in line with AS 9,  ‘Revenue Recognition’ in the context of the two specific end products viz., Maraging Steel Rings and Maraging Steel Plates. Raising invoices on the final customers is not relevant for revenue recognition under AS 9.
 

(b) AS 7, ‘Construction Contracts’, is not applicable for revenue recognition in respect of production items viz., Maraging Steel Plates and Maraging Steel Rings, as mentioned above. 

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